Chapter 17 Management of Accounts Receivable and Inventory

1. Chapter 17Management of Accounts Receivable and Inventory Finance 312

2. Receivables Management • For a firm to grant credit to its customers: • Establish Credit and Collection Policies • Evaluate Individual Credit Applications • Credit Management as a Career Finance 312

3. Accounts Receivable A/R • Large investment for most companies • Essentially an investment decision • Extend credit whenever the marginal returns from extending credit exceed the marginal costs • Liberal credit policy provides returns in the form of increased sales and gross profit, but... • Costs Cost of funds Costs of credit checking Collection costs Increase in bad debts • Trade credit/ Consumer credit Finance 312

4. Credit Policy • Credit standards • Criteria used to screen credit applications • Controls the quality of accounts • Credit terms • Conditions under which credit extended must be repaid (including discounts) • Use of Electronic Data Interchange (EDI) • Collection efforts • Methods employed in an attempt to collect payment on past due accounts • Think of the picture “Rocky I” • Credit line Finance 312

5. Credit Standards • Quality • Time a customer takes to repay • Probability a customer will fail to repay • Default risk - Dun & Bradstreet Rating • Measures of quality • Average collection period • Bad-debt ratio • Balance between too lenient and too strict • Too restrictive a policy - lost sales and profits • Too lenient a policy - Higher investigation costs, Bad debt losses, collection costs, high investment in A/R Finance 312

6. Net Change in Pretax profits Associated With Granting Credit • Marginal profitability of additional sales = Profit contribution ratio X Additional sales • Additional investment = Additional ave daily sales X Ave collection period • Cost of additional investment in A/R = Additional investment in A/R X Pretax required return • Additional bad-debt loss = Bad- debt loss ratio X Additional sales • Additional collection expenses • Cost of additional investment in inventory = Additional inventory X Pretax required return • Net change in pretax profits = Marginal returns - Marginal costs Finance 312

7. Credit Terms • Credit period • Time allowed for payment • e.g. 30 days • Cash discount • Allowed if payment is made within a specific period of time • Specified as % of the invoiced amount • Granted to speed up collection of A/R • e.g. 2/10, n/30; 2/10 EOM, n/30 • Kinked demand curve if oligolopistic competition exists and everyone changes their terms. Finance 312

8. Credit Terms (Concluded) • Seasonal dating (Not a “Social Event”) • Offered to retailers on seasonal merchandise • Accept delivery well ahead of peak season • Pay shortly after peak sales • Advantages • Promotes sales - goods are on hand • Reduces manufacturing inventories • Allows producers to smooth production and distribution • Assists retailers in financing inventory • e.g. O.M. Scott Finance 312

9. Collection Efforts • Methods employed to attempt to collect payments on past due accounts • Letters • Telephone Calls • Personal Visits • Collection Agencies • Legal Proceedings • Balance between leniency and alienating customers Finance 312

10. Collection Efforts (Concluded) • Monitoring status • Average Collection Period • Aging of Accounts Analysis • Classifying accounts into categories according to the number of days they are past due • Changes in the age composition of accounts may reveal changes in the quality of A/R • Both methods are affected by fluctuations in sales Finance 312

11. Analysis of a Change in Credit Policy • Increase in the credit period • Increase the quantity of goods sold • Increase in profits • Cost increases from additional investment in A/R, collection costs, bad debt costs • Liberalization of cash discount • Increase in sales & pretax profit contribution • Reduction in A/R balance • Additional income from alternative investments • Decrease in cost of funds • Reduction in cash revenue Finance 312

12. Analysis of a Change in Credit Policy (Concluded) • Increase in collection effort • Reduced sales and pretax profit contribution • Increased collection expenses • Possible reduced bad-debt losses • Size of Credit Line • Limits are not as enforced as rejection • How large a line? Finance 312

13. Evaluation of Credit Applications • Gathering information • Experience with customer • Credit reporting agencies - e. g. Equifax • Banks • Financial statements submitted by applicant • Personal visits • How much does the analysis cost ? • Begin with the least costly and time consuming source • Is it worth it to proceed further? Finance 312

14. Evaluation of Credit Applications (Concluded) • Numerical scoring system • Multiple Discriminant Analysis (MDA) • Expert systems • Six C’s of credit • Character • Capacity • Capital • Collateral • Conditions • Country Finance 312

15. Inventory ( INV ) • Buffer in the procurement-production-sales cycle • Role of Electronic Data Interchange (EDI) • Flexibility • Timing the purchase of raw materials • Scheduling production facilities & employees • Meeting fluctuating & uncertain demand • Investment of funds • Benefits & costs of holding inventory • Collaborative Forecasting And Replenishment • Parties exchange data electronically(such as details of future sales promotions, analysis of sales trends) Finance 312

16. Types of Inventory • Raw materials inventory • Stores of items used in production • Quantity discounts • Assure supply in times of scarcity • Work-in-process inventory • Items at some intermediate state of completion • Allows for asynchronous schedules • Size related to length and complexity of production cycle • Finished goods inventory • Items ready and available for sale • Permits prompt filling of orders • Economies of scale Finance 312

17. Costs Associated with an Inventory Policy • Ordering costs • Costs of placing and receiving an order of goods • Carrying costs • Costs of holding inventory for a given period of time • Expressed as • Cost per unit per period • A % of the inventory value per period (e.g. 20%) • Stockout costs • Incurred when a firm is unable to fill an order • Involves: • Lost sales • Rescheduling production • Placing and expediting special orders Finance 312

18. Inventory Control Models • ABC Inventory Classification • Basic EOQ Model • Deterministic Model • Assumes: • Annual demand or usage is known with certainty • Usage is constant - no seasonality • Orders to replenish are instantaneously filled • No need for safety stocks Finance 312

19. EOQ ( Q* ) • Total costs = Ordering costs + Carrying costs • Total costs = ( # of orders per year X Cost per order ) + ( Ave INV X annual carrying cost per unit ) • Total costs = ( D/ Q X S ) + ( Q/ 2 X C ) • Q* = 2SD / C • T* = Q* 365 X Q* or D /365 D Finance 312

20. Inventory Control Models (Concluded) • Reorder Point • Defined as the inventory level at which an order should be placed for replenishment of an item • Extensions of Basic EOQ Model • Nonzero lead time • Probabilistic inventory control methods • Just-in-time inventory systems n = X D 365 Finance 312

21. Conclusion • Receivables Management • Credit Policy • Credit Standards • Credit Terms • Collection Efforts • Credit Line • Evaluation of Credit Application • Inventory Management • Inventory costs • EOQ Finance 312